Directors and the expectation gap

Articles Written by Damian Reichel (Partner)

The Australian Institute of Company Directors' survey published earlier this month, suggesting that directors' commercial decision making, even their willingness to serve, is diminished by personal liability concerns, has led to a somewhat predictable reaction to the effect that if directors can't stand the heat they should depart the kitchen. These opposing positions suggest that, as one commentator put it, there is "an expectational gap between what people think directors do and what they actually do".

An expectation gap matters, because investors with wrong expectations will have a wrong perception of risk. 

Legislation is partly to blame - making directors personally liable for failing to anticipate things that can go wrong in the day to day operations of a company in areas like occupational health and safety and environmental protection. Imposing liability for lack of prescience tends to attract the infection of what the Americans call "hindsight bias" - the tendency for people with knowledge of an outcome to exaggerate the extent to which they believe the outcome should have been predicted. It creates an unreal expectation of what directors can do.

The Corporations Act and Court decisions on its application in particular circumstances have taken a more sensible approach. The main duty, to exercise care and diligence, is satisfied if directors make judgments in good faith, do not have a material personal interest in the subject matter, inform themselves, and rationally believe that their judgements are in the company's best interests - and they are taken to have a rational belief unless no reasonable person in their position could possibly have that belief. The centrality of this "business judgment rule" was underscored in the decision in favour of Jodee Rich in the OneTel litigation brought against him by ASIC.

Instances where public company directors have been found liable for dereliction of duty are rare, and will be rarer following the OneTel decision. Why is that? Because public company directors generally are fundamentally honest and competent, as the law clearly requires, and the Corporations Act accepts that their good faith judgments should not be second guessed. In business, risks must be taken and loss could result.  It happens.

Yet the call for directors' scalps whenever there is a major company failure continues.

A degree of spleen venting against directors of a failed company by investors via the media is understandable and arguably appropriate - perhaps some lessons could be learned.  The director can, if they wish, respond to the criticism.

However, where that leads to a reaction by ASIC, the complexion changes dramatically. The directors are "under investigation by ASIC".  Directors can be under that cloud for years, and are required by law to remain utterly silent about it. In the absence of obvious misfeasance (rare) all that is left is the possibility of finding a wrinkle in the company's paperwork which might be taken (with the full benefit of hindsight) to have predicted the company's demise but which was overlooked. As time goes on, media pressure on ASIC to "do something" reaches a peak, then it subsides and the investigation peters out. Or ASIC hands over documents and transcripts to the company's receiver or liquidator to see what they can make of them. ASIC rarely, if ever, comes out and says it has found nothing wrong.  But the directors' reputations can never properly recover.

Rough justice? Some might say that, but surely if allegations can be made, they should be made, and made promptly, so that the accused can respond.

More fundamentally though, ASIC's drawn out investigation process has two deleterious effects. Firstly, it legitimises the expectation gap: if every major company collapse warrants years of investigation, it must be because the directors can generally be assumed to be in some way legally responsible for failing to prevent it. Secondly, it suggests that ASIC is ineffective, by failing to sheet home that responsibility. ASIC is an effective regulator but it is important that it is also consistently seen to be effective.

ASIC should investigate every major corporate collapse as a matter of course, but it should move quickly. The question should be whether any of the directors had their hands in the till, or got a kickback from someone, or was demonstrably asleep at the wheel.  If there is no clear evidence of any of that, the prompt investigation should conclude with a clear public statement that ASIC has found nothing untoward. That may result in investor and media criticism but strong leaders can weather criticism and gain respect for their decisiveness - and over time the expectation gap will be narrowed and investment risk will be better understood. 

And there will always be occasions for ASIC to aim its potent firepower at directors (few though they may be) who are dishonest or demonstrably incompetent.

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